What are Cash Equivalents?
Cash Equivalents Definition
Cash equivalents are highly liquid investments that are easily convertible into cash and carry a low risk of loss of principal. Examples of cash equivalents include short-term, high-quality debt securities such as government treasury bills, commercial paper, and money market funds.
Cash equivalents are typically used by investors and businesses to park their excess cash for short-term periods and to earn a small return while safeguarding their principal.
Some additional information on cash equivalents includes:
- Characteristics: Cash equivalents are characterized by their high liquidity, short maturity period (usually less than three months), and low credit risk.
- Investment Purpose: Cash equivalents are used as a temporary investment carrying a low risk of loss of principal, and they are considered a better alternative to keeping large sums of cash idle.
- Accounting Treatment: Cash equivalents are considered part of a company's cash and cash equivalents on their balance sheet.
- Yield/Returns: Although cash equivalents generate lower returns than longer-term investments, they earn more than cash deposits and offer better liquidity.
- Risks: Although cash equivalents are typically considered low risk, there is always some degree of risk associated with any investment. For example, there is a risk that interest rates may rise, causing a decline in the market value of the cash equivalent.
Here are a few additional points regarding cash equivalents:
- Investment Options: Some common examples of cash equivalents include treasury bills, certificates of deposit, commercial paper, and money market funds.
- Comparison to Cash: Cash equivalents are not the same as cash. While cash equivalents can be easily converted to cash, cash itself is not always considered a cash equivalent. As an example, a company may have a large amount of cash on hand but chooses to invest it in cash equivalents, such as short-term government securities or money market funds.
- Opportunity Cost: While cash equivalents reduce the risk of loss associated with holding cash, they also involve an opportunity cost. This is because the return on cash equivalents is relatively low compared to other types of investments. Hence, investors need to weigh the cost of low returns against the security of holding cash equivalents.
- Benefits to Companies: Cash equivalents hold significant benefits for companies, such as meeting short-term cash requirements, paying off debts or dividends, and providing a buffer for unforeseen expenses such as unexpected bills for maintenance or repairs.
Overall, cash equivalents are valuable instruments that provide investors with a short-term, low-risk, and highly liquid way to invest their funds.
